Definition of Senior Security
Senior security refers to a type of financial instrument that holds a higher claim on assets and earnings compared to junior obligations and equity. In the hierarchy of repayment during liquidation, senior securities are given priority over junior securities. Common examples of senior securities include notes, bonds, and debentures. Within the debt structure, mortgage bonds are categorized in levels of priority, with first mortgage bonds being senior to second mortgage bonds, and all mortgage bonds holding seniority over unsecured debentures.
Examples of Senior Security
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First Mortgage Bonds: These bonds are backed by the pledge of specific assets, typically real property, and have the highest priority claim on the assets of the issuer in the event of liquidation.
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Corporate Bonds: General category of senior debt instruments secured by the corporation’s assets or earnings, thus having priority over subordinate debt like debentures.
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Debentures: Unsecured bonds that rank below secured debt like mortgage bonds but above all forms of equity.
Frequently Asked Questions (FAQ)
What distinguishes senior from junior securities?
Senior securities have a higher claim on a corporation’s assets and earnings compared to junior securities. In liquidation, senior securities are repaid first.
What types of debt are considered senior securities?
Senior securities include notes, bonds, and debentures. First mortgage bonds are an example of highly senior debt, followed by second mortgage bonds, then debentures.
Are stocks considered senior or junior securities?
Stocks are considered junior securities because they have the lowest priority claim on a corporation’s assets in the event of liquidation.
What happens to senior securities during liquidation?
During liquidation, senior securities are repaid before any junior securities, such as subordinate debt or equity.
Can the priority of senior securities change?
Generally, the priority of senior securities does not change unless there is a restructuring arrangement or new issuance with a higher priority.
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Mortgage Bonds: Bonds secured by the pledge of specific assets, giving them priority over unsecured bonds (debentures).
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Debentures: Unsecured bonds that are senior to stock but junior to secured debt like mortgage bonds.
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Junior Security: Financial instruments such as subordinated debt and equity that hold lower claim on assets and earnings compared to senior securities.
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Subordinated Debt: Debt that is repaid after senior debt instruments in the event of liquidation and has higher risk.
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Liquidation: The process of bringing a business to an end and distributing its assets to claimants, prioritizing senior claims.
Online References to Resources
- Investopedia - Senior Debt
- Corporate Finance Institute - Senior Debenture
- SEC.gov - Asset-Backed Securities
Suggested Books for Further Studies
- “Corporate Finance: The Core” by Jonathan Berk, Peter DeMarzo
- “Essentials of Corporate Finance” by Stephen A. Ross, Randolph W. Westerfield, Bradford D. Jordan
- “Financial Markets and Institutions” by Frederic S. Mishkin, Stanley G. Eakins
Fundamentals of Senior Security: Finance Basics Quiz
### Which of the following is an example of a senior security?
- [x] First mortgage bond
- [ ] Common stock
- [ ] Preferred stock
- [ ] Subordinated debenture
> **Explanation:** A first mortgage bond is considered a senior security because it has a higher priority claim on the issuer's assets compared to stocks and subordinated debt.
### During liquidation, which type of security is repaid first?
- [ ] Subordinated debenture
- [ ] Preferred stock
- [x] Senior bonds
- [ ] Common stock
> **Explanation:** Senior bonds have the highest priority in asset claims during liquidation and therefore are repaid before any other types of securities.
### What type of debt is senior to a debenture?
- [x] Mortgage bonds
- [ ] Common stock
- [ ] Preferred stock
- [ ] Convertible bonds
> **Explanation:** Mortgage bonds are considered senior to debentures because they are secured by specific assets, giving them higher priority in asset claims.
### Which is true about senior bonds compared to subordinated debt?
- [ ] Senior bonds are usually repaid after subordinated debt.
- [ ] Senior bonds carry a higher risk than subordinated debt.
- [x] Senior bonds have a higher claim during liquidation.
- [ ] Senior bonds are always unsecured.
> **Explanation:** Senior bonds have a higher claim on a corporation's assets during liquidation compared to subordinated debt, making them a lower-risk investment.
### What category of securities ranks highest in the repayment hierarchy?
- [ ] Common stock
- [ ] Preferred stock
- [ ] Subordinated debentures
- [x] Senior securities
> **Explanation:** Senior securities rank highest in the repayment hierarchy, getting repaid before any junior securities during liquidation.
### Which is typically true about the interest rates of senior securities?
- [ ] They have the highest interest rates among all securities.
- [x] They usually have lower interest rates than subordinated debt.
- [ ] They do not have any interest rates.
- [ ] Their interest rates are the same as common stock dividends.
> **Explanation:** Senior securities often have lower interest rates compared to subordinated debt due to their higher priority and lower risk.
### Why might an investor prefer senior securities over junior securities?
- [ ] For their high appreciation potential.
- [x] For their higher claim on assets and lower risk.
- [ ] For their complex investment structure.
- [ ] For their minimal regulations.
> **Explanation:** Investors prefer senior securities for their higher claim on assets in the event of liquidation and generally lower risk compared to junior securities.
### What does it mean if a bond is 'secured'?
- [ ] It has no backing assets.
- [ ] It is riskier than unsecured bonds.
- [x] It is backed by specific assets of the issuer.
- [ ] It offers no interest payments.
> **Explanation:** A secured bond is backed by specific assets of the issuer, providing a collateral that lowers the risk for investors.
### In the hierarchy of claims, where do common stocks stand?
- [ ] Above subordinated debt but below preferred stocks
- [x] Below all forms of debt and preferred stocks
- [ ] Above senior and subordinated debt
- [ ] On the same level as senior bonds
> **Explanation:** Common stocks stand at the bottom of the hierarchy of claims, getting repaid last if any assets remain after all debts are settled.
### How does the presence of senior securities affect a company’s capital structure during liquidation?
- [ ] It simplifies the liquidation process.
- [ ] It elevates the priority of stockholders.
- [x] It prioritizes repayment to those holding senior securities first.
- [ ] It reduces the number of creditors.
> **Explanation:** During liquidation, the presence of senior securities means that those holding these securities are repaid first, prioritizing their claims over those of junior securities holders.
Thank you for exploring the concept of senior security and challenging yourself with our targeted quiz questions. Continue deepening your financial knowledge!
